I recently read an article about a hedge fund doing a $2 Billion dollar debt deal to lock in a 1.67% annualized return over 5 years. A measly 1.67% annualized return? If that’s the line to gain then I am going into the hedge fund business! Caution, much irreverent satire to follow…
Scana Corp. owns a power utility called Santee Cooper in South Carolina and Santee Cooper was going to build some nuclear reactors down that way. Scana contracted Westinghouse Electric Co. which is owned by Toshiba to build these reactors in South Caroline for Santee Cooper. Follow so far?
Westinghouse ended up mis-managing the projects and was beset with cost overruns and all sorts of managerial problems. Eventually Westinghouse ended up going bankrupt and abandoned the project. Scana Corp. understandably went nuclear and successfully sued Toshiba for $2.2 Billion in an effort to salvage their investment in the projects, winning a judgment where the $2.2B was to be paid by Toshiba to Scana over the next 5 years. Still following?
Where Do The Hedge Funds Come In?
So Scana has $2.2 Billion coming its way over the next 5 years, but needs the money NOW in order to fund their operations and finish these reactors. Furthermore, Toshiba is not in the best of shape, financially speaking, so Scana does not want to assume the risk of Toshiba ending up going bankrupt before they can pay this judgment in its entirety. So what did Scana do?
According to the article by Bloomberg Scana worked with Citigroup, Inc. to offer the $2.2 Billion worth of payments over the next 5 years up for sale in exchange for a lump sum payment equivalent to 92 cents on the dollar today. Curious… Who bought the debt? A yet to be named Hedge Fund(s). What in the hell? Who would take this trade?
If I pay you $92 upfront for a cool Benjamin that’s a pretty good rate of return. I’ll take an instant 8% any day of the week. Hell, I’ll give a year to re-pay me for an annualized return of 8% collateralized against your knee-caps should you fail to produce said Benjamin on time.
However, if I pay you $92 upfront for $100 that I won’t fully realize until five years from now via 5 yearly payments of $20 per year, that’s an annualized rate of return of 1.68% per year on my investment. That’s also a horrible rate of return that also assumes the risk of you losing your job, losing my address, getting hit by a bus, or spending all your money on a crazy girlfriend anytime in the next 5 years as well. No thanks. Bashing your knee caps would be crunchy fun, but it’s not worth bloodying up a perfectly good Louisville Slugger for that kind of measly action.
So what is this hedge fund(s) up to? They are buying a pathetic rate of return along with a quantifiable risk of Toshiba not being around to pay up 5 years down the road (default risk). Seeking safety? Seeking secure payments? Seeking what?
Most hedge funds have a fee structure called 2 & 20 or 2/20, which means they charge 2% per year PLUS 20% of the profits they generate. What kind of professional investing outfit takes a trade that offers an annual return that is less than the annual fees they charge their clients? I know it’s not their only position and ostensibly their entire portfolio will generate a much higher return, but come on…
Man on the Move Style:
If this hedge fund’s end goal is a safe 5-year return to smooth out their volatility or hedge out some risk in their portfolio, the Man on the Move would’ve steered them fund toward a 5-year Treasury note where the yield currently runs 1.91%. That’s more than a 12% greater return over the same timeframe with a default risk hovering at zero with the advantage of much lower transaction costs and a more liquid holding. This is a no-brainer, right? Furthermore, this trade would’ve taken me about 5 minutes to find and about 5 minutes to execute.
To whoever did this debt deal with Scana, please let me run your hedge fund…
Ten years ago Warren Buffett made a famous $1 million bet with a money management firm called Protégé Partners. Buffett bet that a passive S&P500 index fund (he picked the ubiquitous Vanguard Admiral Shares S&P 500 Index Fund) would beat Protégé’s ‘fund of funds‘ consisting of 5 hedge funds (an ‘all-star’ holding if you will) over the course of 10 years from 2007-2017. What happened next was utter destruction as Protégé Partners got their asses handed to them by Mr. Market.
The bet will officially end in December of this year but the fat lady has already sung. In fact, she’s finished her encore as well. Of the 5 hedge funds in Protégé’s basket, not a single fund is outperforming the S&P index. Only one fund comes even remotely close, yet still trails the index by more than 25%. Three of the five funds in the basket have average annualized returns below 1% (well less than half the rate of 10-year T-bills over the same timeframe). What did Protégé Partners charge for such an ass-whipping? You can enjoy this beatdown for a mere 3.25% per year. What? According to Protégé’s website, the fund employs over 30 professionals. This is the best they can do in the biggest bull market in modern times?
As of December 2016 the S&P 500 was up 85%, versus 22% for this ‘all-star fund of funds’, leading Protégé to throw in the towel and admit defeat with still a year to go on the bet. While the names of the hedge fund components in the ‘all-star fund of funds’ remain a secret (to protect the guilty I suppose), Buffett does have access to the data. He has estimated the hedge fund fees accounted for (get this) 60% of Protégé’s pre-fee return. This would suggest the funds returned about 55% before fees and 22% after fees. How many ways can you say ‘ouch‘. Protégé investors saw their already feeble returns annihilated by inexplicable fees, and they lagged the performance of a simple S&P500 fund that returned a whopping 85% over the same timeframe. Shame…
This led Buffett to announce at his last Berkshire Hathaway shareholders’ meeting; “There’s been far, far, far more money made by people in Wall Street through salesmanship abilities than through investment abilities…” Obviously the crowd roared with laughter. I’m not sure if they were laughing at Buffett’s quip or Protégé’s performance – probably a little bit of both, right?
I think it’s fitting that The Oracle of Omaha laid waste to an outfit called Protégé – Definition: One whose career is advanced by a person of experience; well trained.
Man on the Move Style:
My move in this bet would’ve been simple. I would’ve attempted to beat Mr. Buffett and the S&P500 by simply adjusting the weighting of the S&P500 itself. I would correlate my investment to the same index, but attempt to generate alpha (excess returns of a fund relative to the return of a benchmark index) by tilting more towards the middle and smaller end of the companies within the fund.
This strategy is simple, efficient, and with the RSP equal-weight index fund (which I have written about several times before) it will cost 0.20%/year versus 0.04% for the Vanguard fund. Admittedly, that is far more expensive than the Vanguard fund, but sill a huge bargain compared to Protégé Partners’ laughable 3.25%.
Over 10 years RSP has returned an annualized 8.31% versus Vanguard’s 7.57%. Had Buffett and I both dropped $1,000,000 into our chosen investments for the past 10 years, the final scoreboard would look like this:
- Me: RSP returns $2,177,664 after I pay $31,520 in fees.
- Warren: VFIAX returns $2,066,209 after he pays $8,283 in fees.
- Protégé: est. returns <$1,300,000 after collecting est. fees >$300,000
Looking at these hypothetical returns shows you the impact fees can have on your investments. Over 10 years I paid a lot more money into the financial machine (almost 4 times more!) though I did eek out 5.12% more in total return. I am, however, feeling pretty good about where I sit in terms the Protégé ‘all-star fund of funds’. Man, I bet these guys have some cool office space, eat crazy-expensive lunches, and drive really fast cars…
To whoever picked this ‘fund of funds’ for Protégé Partners, please let me run your hedge fund…
Hedge fund managers, please note: I have no expensive letters after my name, and I have no degrees in finance, accounting, or business from any fancy school. Furthermore I do not own a suit, I’ve never worn a suit, and I will never be seen in a suit. I drive a Toyota Corolla, I will prefer a quick protein shake for lunch over caviar and martinis, and I will not be making the Starbucks run with your office staff 3 times per day. I plan to work about 5 hours per week, which will give me ample time to read the news, make a few trades, and exceed your returns. I plan to drink some beer in the office, listen to Soundgarden while I trade, tell some dirty jokes on occasion, and voice much irreverent disdain for the financial industry on a regular basis. In return I feel confident I can slaughter your asses in terms of performance. Your staff will hate me because we can let about 90% of them go. Your clients will love me because I will save them millions of dollars in fees. What is more important to you? So again I ask…
Please let me run your hedge fund…